Options Trading Education

Succeeding in Options Trading

T.D. Thompson — Thu, 29 Jul 2010 02:39:24 +0000

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The beginning options trader may run across ads on the internet promising automatic profits in trading options. Anyone making a living trading options knows that profits are not automatic and that succeeding in options trading requires knowledge, dedication and skill. On the other hand succeeding in options trading is absolutely possible for those involved in occasional options trading as well as the professional.

The basics start with things like knowing the difference between strike prices and spot prices in options trading. The strike price is the price agreed upon in an options contract. This is the same price whether the contract is a put or a call. The spot price is the current market price. Succeeding in options trading comes down to the ability to accurately forecast whether the spot price of the equity underlying the option will diverge significantly from the strike price. If so the question is how much of a difference will occur which will determine potential profit. Traders who expect the strike and spot price to diverge will either buy calls or puts depending upon if they thing the spot price will go up (calls) or down (puts). Traders who do not believe that the spot price will to up from the strike price will sell calls and those who do not believe that the spot price will go down from the strike price will sell puts.

The next part of succeeding in options trading is the dedication needed to learn the tools used in predicting equity price movement. This is the world of technical analysis. Markets tend to repeat themselves and the repetition of equity price patterns is predictive of subsequent price direction. Learning the multiple price patterns that predict subsequent market price movement is one of the bases of succeeding in options trading. The other basic aspects of trading that a trader needs to learn and integrate into either a long options strategy or short options trading strategy is when to trade and when to observe. The advantages of options trading are that the trader only invests a small amount of his or her money to buy the contract premium. This provides a substantial leverage in the event that the underlying equity price moves dramatically. However, more often than not price movement does not lead to profits in options trading. This is why large institutional investors typically make their money selling calls and puts and not buying them. Learning when to stay out of a trade can be as important as knowing when jump in.

The final part of succeeding in options trading is realizing that the act of trading is essentially a performance art. It is done by human who get nervous, get cocky, get tired, and can do dumb things. It is also an art that be performed with stellar results. Part of risk management in options trading is keeping a cool head in a volatile market. Part of succeeding in options trading is knowing that times of chaos and high volatility are good times for options trading when the trader is knowledgeable, dedicated, and skilled in his art.

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Options Trading Leverage

T.D. Thompson — Sat, 24 Jul 2010 01:20:53 +0000

Options trading leverage is what attracts many to options trading. In the various kinds of options trading, the ratio of change of the price of the option to the change in the underlying equity price is the delta. For example, a delta of 0.8 means that for every dollar the equity changes the option price changes 80 cents. The delta is also called a hedge ratio. Options trading leverage is demonstrated in the example of buying stock versus buying call options on a stock with a delta of .8. If the stock sells for $10 a share the trader could buy 100 shares of the stock for $1,000. If the trader buys an out-of-the-money call option for $1.50 a share that will cost $150. Providing that the trader has done his or her homework the equity in question will rise in price before the expiration date. The options trading leverage in this situation is that with a delta of 0.8 the option value will rise 8 cents for every 10 cents that the equity price rises. However, the initial option investment is 3/20th of that of buying the stock. If the stock goes up a dollar the investor will gain $100 on an investment of $1,000. The trader will gain $80 on an investment of $150.

Many traders favor out-of-the-money options with distant expiration dates. These options are usually quite cheap, sometimes cents a share. Out-of-the-money call options are call options on stocks that are trading below the strike price of the options contract. The strike price is the price at which the option will sell if the purchaser chooses to execute the options contract. If a call option is out-of-the-money its only value is its “time value.” The longer the time until the option expires the more time there is for the price of the underlying equity to move. This is the option’s speculative value and will gradually decrease as the time until contract expiration decreases. So, what is an option worth? It is worth its intrinsic value plus its time value. It will be worth a lot more if the underlying equity goes up in price. Options trading leverage makes the investment in a call option potentially more valuable, dollar for dollar, than the purchase of the same stock.

If the trader is buying puts instead of calls, movement in the option price versus the equity price is expressed as a negative delta. If the buyer buys a put on a similar and out-of-the-money option it will be a situation where the equity is selling above the strike price. If the price of the equity goes up it counts as a potential loss for the options trader as is expressed as a negative number. However, the underlying ratio will be the same. When selling puts the options trade is compared to selling the stock short. The trader will incur a larger potential expense in selling short than in selling the put. This situation has a similar degree of options trading leverage although it involves selling with a short options strategy versus selling a put. As with all investments in options the trader needs to study the fundamentals of the underlying equity and the technical aspects of market movement. Deciding to buy calls or puts on an equity depends on where the trader thinks the equity price will go and it depends upon doing the math involved to know where the profit can be.

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Buying Puts on the Financial Select Sector SPDR

T.D. Thompson — Tue, 29 Jun 2010 15:01:31 +0000

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Buying puts on the financial select sector SPDR multiplied recently as the government entered into consideration of new regulations. Puts to sell outnumbered calls to buy by roughly twenty to one as the SPDR fund price fell nearly two percent, to just above $14 a share. The huge difference has arisen as congress is debating the final terms of new regulations for the financial industry. Poor oversight and banking sector excesses are commonly blamed as major causes of the 2008 market crash. However, many banking insiders are concerned that the upcoming restrictions will damage the financial industry as it tries to get on its feet again. An example of the proposed regulations is that banks may be restricted from trading derivatives. SPDR funds are shares of a family of exchange-traded funds (ETFs) traded in the United States. These funds are managed by State Street Global Advisors. The acronym SPDR comes from the first ETF in the fund, Standard and Poor’s Financial Services Depository Receipts which is designed to track the S&P 500. These funds are set up as unit investment trusts. The financial select sector SPDR a range of financial service firms including JPMorgan Chase, Wells Fargo, and BankAmerica Corp. With new regulations on the way it may be bad times for the financial sector but times of volatility are good times for trading options.

The kinds of options trading that are most profitable will depend upon what the market in the underlying equity is doing. Put call ratios are running around sixteen to one on individual stocks across the financial sector as traders fret over the consequences of tougher regulations on financial sector profitability. Traders buying calls is a sign of faith in the likelihood of stock prices going up. Traders buy puts in the belief that a stock price will go down. If the large majority of traders buying puts are correct then they will be able to sell Financial Select Sector SPDR shares at the strike or contract price at a time when the spot price or market price has dropped substantially. Traders will buy at the spot price and sell at the strike price, pocketing the profit. Traders believe that buying puts on the financial select sector SPDR will lead to profits.

As usual we are not suggesting buying puts on the financial select sector SPDR or buying calls for that matter. This is an exercise in watching market indicators such as the daily put to call ratio and using that information to find advantageous situations for uncovered options trading. When a trader sees a great deal of market volatility but does not know which way the market will go he or she may engage in a long straddle options strategy. In this strategy the trader will buy a call and buy a put on the same equity with the same option expiration date. This strategy costs the trader two premiums but insures that he or she will profit no matter which way the equity price goes. The only way to lose on a long straddle is if the market quiets down and the equity price remains stable. In that case the trader is out the cost of two premiums. If the trader really believes that the equity in question has stabilized then selling both puts and calls can be profitable. This is a short straddle. The profit is two premiums if the equity price does not change but the loss can be substantial in either direction if the price moves dramatically. The point of being aware of the fact that the market is buying puts on the financial select sector SPDR is that knowledge properly used leads to profits in options trading.

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Trading Steel Options

T.D. Thompson — Tue, 22 Jun 2010 02:41:41 +0000

There is opportunity in steel price volatility. North American steel producers are pressuring officials in Canada, Mexico, and the USA to put pressure on China to revalue the Yuan. Their goal is a “large and sustained appreciation” of the Chinese currency. A more expensive Yuan would drive up the price of Chinese steel and make North American steel more competitive. The argument goes that a stronger Yuan would lead to a faster economic recovery in the West, more jobs, and more wealth. Trading steel options could be lucrative at this moment as stock prices of US steel manufacturers are severely “corrected” and ready to rebound. Bad times for owning stocks are often good times for trading options. The issue of currency rate changes, possible bans on Chinese imports if congress declares China a currency manipulator, and the question of a double dip recession all lead toward stock price volatility and possible profits in trading steel options.

There are several factors that could affect steel prices, the price of steel stocks, and profits in trading steel options. The currency manipulation issue is about to move into congress where there is substantial bipartisan support for labeling China a “currency manipulator.” If a bill passes administration will be forced to take action through the IMF and WTO. US industries, including steel manufacturers, will be allowed to sue in US courts for damages. Whether these actions change the price of steel and the profits of US steel companies is not as important is the various perceptions that will tend to drive stock prices up and down. There are various kinds of options trading that could be applied to trading steel options. Certainly, if one believes that US steel makers have taken their hit and are due for an upswing, buying calls on these stocks could be lucrative. If one believes that US efforts to adjust China’s currency are going to be successful then buying calls could be doubly effective. If it is the volatility of steel prices and the price of steel stocks that seems most worrisome, then using a straddle strategy (long) will position the trader to profit whether steel stock prices rise or fall.

As usual the point of all this is not to go out and buy or sell options on steel stocks or to avoid doing so. It is to find opportunity in the chaos that is the larger equity market of today. The trader will need to stay abreast of changes in the larger economy and in the fortunes of individual companies finding markets for new products. The use of covered options trading or uncovered options trading, a short straddle or a long straddle, will have to do with individual options trading strategies based upon reasonable expectations what the market will do before given options expiration dates. Although you may expect the Chinese to revalue the Yuan or for their economy to stagnate under a load of debt the question is how soon and how soon is critical to options trading. If China decreases steel production how long will stockpiles last and how soon will prices climb in the West? Trading steel options could be quite lucrative, depending upon what happens in many arenas, and how soon.

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Trading Gold Options

T.D. Thompson — Wed, 09 Jun 2010 00:25:54 +0000

As the price of gold overtakes the dollar’s rise, trading gold options could be a good idea. In tough economic times there tends to be a flight to the dollar and a flight to gold when other currencies appear threatened. Part of the recent rise in the value of gold was masked by the rise of the dollar a couple of days ago. Nevertheless gold went up $12.20. Which way will gold go? Which way will the dollar go? Trading gold options will give the trader the option to buy or sell gold based investments but not an obligation. Gold mining stocks and gold funds offer the trader the opportunity for hedging their bets on gold with strategies such as a long straddle.

Gold mining stocks typically outperform gold bullion during an upswing in gold prices and may fall more dramatically when the price of gold drops. For gold bugs it is a matter of buying at the bottom and trying to get out at the top of the curve. The options trader has, well, more options. Buying puts on gold mining stock will allow the trader to profit from a downswing in the stock price and buying calls on the stock will allow him or her to profit from a price surge. Using a long straddle strategy the trader will buy both calls and puts on the same gold mining stocks with the same options expiration dates. Companies such as Barrick Gold, Newmont, Kinross Gold, Freeport McMoran, Anglo Gold Ashanti, Goldcorp, Newcrest Gold Fields, Harmony, Eldorado Gold, IAMGOLD, Lihir Gold, Centerra Gold, and Highland Gold are a short list of gold mining and exploration companies. Using a long straddle strategy in buying puts and calls on gold mining stocks will cost the trader the price of two premium but will offer the opportunity of a profit on either a rise or fall in stock price as the price of gold varies with the price of the dollar and world wide economic uncertainty.

Gold funds offer a similar opportunity in trading gold options. Because gold funds are more closely tied to the price of gold they may be amenable to different kinds of options trading than gold mining stocks. For example, if a trader believes that the price of gold will trade within a reasonably tight range over the next few months a short straddle strategy might be profitable. In this case the trader stands to earn the price of two premiums on his or her trades. However, it is important to realize that, although selling puts and calls tends to be more profitable over the long run, a short straddle opens the trader up to risk if the price of gold and the stock move substantially in either direction. It is because of the risk of substantial loss in selling puts and calls that most of this sort of options trading is done by large institutional investors with deep pockets. As usual we are not suggesting that one engage in trading gold options or avoid trading gold options. The point is to be aware of how market movement, investment uncertainty, and economic difficulties open the door to opportunity in trading options.

Crisis Options Trading

T.D. Thompson — Mon, 31 May 2010 01:35:14 +0000

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Crisis options trading is emerging as European debt worries continue and investors ignore promising US job data. In times of great volatility and brewing crisis options traders tend to use strategies such as a long straddle where they buy both a call and a put on the same stock with the same expiration date. In crisis options trading the trader is not sure which way the market will go but is certain that volatility will take it one way or the other. Also in times of crisis traders typically sell their stock and deal almost exclusively in options until the current storm blows over. The Chicago Board Options Exchange (CBOE) volatility index, the VIX, has been high recently, hitting a peak on May 7. The VIX is often referred to as the anxiety index and high numbers often lead to crisis options trading.

Many traders are forsaking covered options trading as they are selling their stock. However, because very few traders are interested in selling puts or calls because of the uncertainty of the market the stampede to uncovered options trading does not really matter. No buyer has to execute a contract unless he or she will profit and then the trader will simultaneously execute the contract and execute a covering trade, pocketing the profit. In times of great market volatility such as these the only ones selling options contracts are the large institutional investors with really deep pockets and even those folks seem to have backed off a bit.

The use of a long straddle options strategy in crisis options trading works to provide opportunity at limited risk. It is one means of implementing risk management in option trading. The trader believes, based upon both market fundamentals and technical charts, that the market is set to move up or down, perhaps dramatically. By buying both a put and a call on a stock the trader is assured of a profit either way the stock moves. The risk is that the market will stabilize and the trader will be out two premiums. Timing can be everything in crisis options trading. It is important that the options expirations dates for contracts purchased in this type of trading are far enough out that whatever is going to happen will have time to happen. There are few things worse than buying a cheap options contract that has a few days to go and then having the stock price move dramatically the day after the contract expires.

There are different kinds of options trading for different times and different purposes. A more conservative approach is often warranted in times of pending economic crisis. Despite a well publicized trillion dollar aid package aimed at supporting debt repayment in the PIIGS (Portugal, Italy, Ireland, Greece, and Spain) countries. Thus we see than many traders are divesting themselves of their stock and only buying options. Thus they have a large cash position and the option to buy stock or sell stock at the strike price should the spot price move substantially up or down.

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Good Times for Trading Options

T.D. Thompson — Wed, 26 May 2010 14:12:17 +0000

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Bad times for investing in stocks are often good times for trading options. Such are the times today. Volatility is the order of the day. One is reminded of Alvin Toffler’s book, “Future Shock,” in which he, correctly, predicted 40 years ago that society would not only change going forward but that the rate of change would progressively increase. So it seems with current market volatility. For someone with a nest egg looking forward to a comfortable, safe, and secure retirement the market today stinks. For the options trader with sufficient capital today’s volatile market provides virtually unlimited opportunity. Today would seem to be a much better time for a long straddle on many stocks than for a short straddle on almost anything in sight.

The uncertainty that produces volatility is infectious to the point where many strong companies with good balance sheets and lots of cash get pulled into a cycle of fear. Companies selling things like basic laundry soap, basic phone service, and replacement spark plugs will not likely ever go out of business although such companies, according to fundamentals, will never see their shares multiply a hundred fold. Nevertheless these companies often suffer as the market fear factor sinks all ships. Just like the value investor looks for intrinsic value in stocks the options trader can look past the fear factor for strong fundamentals, watch for technical indications of price movement, and buy options where there is promise of profit. Using a long straddle the trader is betting on price movement and is not sure if it will be up or down. He or she is betting on extreme price volatility. Using a short straddle strategy the trader believes that price volatility, at least for the stock in question, will cease, entirely. If he or she is wrong the results can be devastating. This is why much of the business of selling options resides in the halls of large institutional investors with very deep pockets. Looking at the two kinds of options trading, buying versus selling, buying seems a safer and potentially more lucrative proposition during these good times for trading options.

Good times for trading options can also be expensive times for options. Because of the risk inherent in a volatile market the sellers of puts and calls will be asking for higher premiums. The view of the buyer will be that the price is high. The view of the seller, who is assuming all risk, is that the price could be far too low. Thus the trader need be mindful of the degree of opportunity a option offers and just how much the underlying need change in price for the purchase to be profitable. Risk management in options trading entails a clear view of know cost versus potential profit. However, periodic performance review is essential because potential profits are not profits. The wise trader keeps track of what he or she traded and exactly why he or she picked the underlying to trade at a given premium and given market conditions. This way a trader can trade successfully during bad times as well as good times for trading options. This is how traders develop successful strategies and is a step towards making a living trading options.

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Options Trading CBOE

T.D. Thompson — Thu, 18 Mar 2010 16:22:00 +0000

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After 37 years as a private member owned organization the Chicago Board Options Exchange (CBOE) is filing an initial public offering for up to $300 million. CBOE was the world’s first marketplace for options. Founded in 1973 CBOE’s daily trading volume has reached to over a billion contracts a year. Options trading CBOE seems like a contradiction in terms but options trading CBOE could be quite profitable. All different kinds of options trading you engage in with the CBOE ought to be right at home at the world’s first options exchange.

The CBOE oversees roughly four and a half million trades a day and will soon be overseeing its own. CBOE Holdings Inc. does not say when they will present the IPO or how many shares they will sell. The question for the options trades is if with the ever increasing use of derivatives such as options and online trading the business of CBOE will continue to flourish, making the company an attractive investment. The question for options traders will soon be, what is an option worth if the option is on CBOE?

Once the Chicago Board Options Exchange becomes public it will be eligible for options trading. The same options strategies will apply to CBOE as to any equity. A long straddle will provide the trader with the opportunity for profit is the new stock moves substantially up or down. Options expiration dates will be the same as other options. The only difference from other stocks will be that CBOE options could be listed on their own exchange.

An issue in options trading CBOE is the attention being given to regulating derivatives by the Obama administration. Changes in short selling rules that will take effect in May will include a ban on flash orders. These trading tools give a very brief trading edge to investors. CBOE spokespersons have been quoted as saying that their business will be adversely affected by changes in the rules regulating options trading. What is an option worth may become an issue with trading CBOE options if the government comes down hard on derivatives in general or options in particular. The White House Economic Advisor, Paul Volcker, has been quoted as saying that institutional trading in hedge funds by banks should be restricted which could be a harbinger of less volume in options trading.

Part of risk management in options trading as will apply to options trading CBOE will be keeping up with new regulations. It will also mean keeping up with trader sentiment. There can be a psychological tendency in trading options that will predict a disaster in the options market and for CBOE. That disaster may well not happen. When is trading call options a good option? When is trading put options a good option? If they were good options yesterday they still are today and will be tomorrow. Just because there is current concern about trading volume and flexibility in options trading does not ever mean that trading will go away. Don’t let the current hype about trading regulations distract you from the knowledge that markets go up and down and there is profit to be made going either way.

Options exchange CBOE files for $300 million IPO (seattletimes.nwsource.com)
U.S. Options Exchange CBOE Files for IPO (seekingalpha.com)
Is Option Greed a Worrisome Sign? (seekingalpha.com)

Covered Options Trading

T.D. Thompson — Sun, 07 Mar 2010 16:24:25 +0000

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Covered options trading means trading options on stock that you already own. Covered options trading does not provide the leverage that uncovered options trading does but it is typically safer. Investors usually sell options on stock that they already own to increase their profits. Investors buy put on stock that they already own in order hedge risk. They buy call options to lock in opportunity without a large cash outlay.

Of the various kinds of options trading covered options trading is the most conservative. We will look at buying and selling the covered call option and the covered put option. The covered call option is a long options strategy. Although the investor already owns the stock he or she would be very pleased to buy more but only if the stock is going to go up or continue to go up in price. By purchasing a call option on the stock the investor locks in the opportunity to buy, at the strike price, when the stock’s spot price rises. An investor will typically sell a call option on stock he or she owns if the stock is not likely to go up in price. In this case the investor usually has a cyclical stock that is near its traditional high. By selling a call option on the stock the investor gains the premium paid for the option. The premium helps offset the portfolio loss as the stock cycles back down to its lower range. Because the buyer does not execute the options contract the investor keeps a good stock.

When is trading put options a good option? When you own a stock that has just had a big run up in price and you want to lock in your gains in a volatile market. In this case the investor buys a put on the stock that he or she owns. The put gives the investor the right to sell the stock on or before the contract expiration date at the agreed upon contract price. This price, the strike price, is the current price of the stock after a substantial run up. If the stock correctly heavily the investor will exercise the put option and sell the stock at the contract, strike, price, and buy again at the lower market or spot price. An investor may also sell a put option on a stock that he or she owns.

Whereas buying a put option on a stock you own is a type risk management in options trading selling a put on your stock is just for profit on the premium. This case is similar to selling covered call options. The investor does not expect the stock to fall in value even through the buyer of the put does. The investor expects to gain the premium and to keep a promising stock. If the stock does drop substantially in price the investor will have to buy at the strike price but can use the stock he or she has to help with the cost. If the stock drops very badly then the investor will wish that he or she had been more careful writing puts in options trading. Over the long term writing puts is statistically more profitable than buying them. The problem is having the collateral to cover an occasional bad trade. Owning the stock already provides collateral for the occasional loss in this type of covered options trading.

5 Careful Ways to Win with Options (benzinga.com)
Sprint Nextel Options Actively Traded Suggest a Decrease In Price Movement (S) (benzinga.com)

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Interest Rate Option Trading

T.D. Thompson — Fri, 05 Mar 2010 15:37:19 +0000

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The Chicago Board Options Exchange (CBOE) offers interest rate option trading. CBOE describes interest rate options as “European-style, cash-settled options on the yield of U.S. Treasury securities.” This is one of the kinds of options trading that deals solely in projected interest rates. These options trade in U.S. Treasury bills with short, medium, and long term rates. Options trading terms are the same in trading interest rates as in other options trading.

Interest rate option trading is referred to as trading in yield based options. In trading interest rates on U.S. Treasury bills the individual who buys a call option expects the prevailing interest rate to go up. The individual who buys a put expects the rate to go down. For the buyer of a call option to profit, the underlying interest rate must rise above the strike price by more than the premium paid. For the buyer of a put option to profit, the interest rate must drop below the strike price by at least the price of the premium. In addition, taxes and commissions will figure into the cost analysis for interest rate option trading. For using risk management in options trading the same types of combinations of puts and calls, buys and sells apply as throughout options trading.

Interest rate option trading products offered by CBOE include the thirteen week Treasury bill which trades under the symbol IRX, the five and ten year notes as FVX and TNX, and the thirty year bond as TYX. Strike prices and spot prices in options trading work the same on interest rates as in other options. The buyer profits when the spot price rises or falls from the strike price, depending upon whether he or she purchased a call or a put. The seller is betting that the spot price will not move significantly away from the strike price so that he or she will gain the premium paid for the option and will not lose on a large adverse movement in the interest rate of the product involved.

Options expiration dates for interest rate option trading at CBOE are the Saturday following the third Friday of the expiration month. The option value of interest rate options is ten times the yield of the underlying security. For example an interest rate of 3% on a 5 year bond makes the option worth $30. Interest rate options trading contracts are settled in cash. There is no need to buy or sell the actual bills, notes, or bonds. Contracts are multiples of 100. In the matter of United States versus other options trading interest rate option trading is done in European style. Thus all contracts are settled on expiration, never before. While the multiplier for contract is 100 the strike price intervals are quoted at every two and a half points as opposed to every five points on a standard strike table. A one point interval is 10 basis points. Premiums are quoted as one point for every $100 and are in decimals.

5 Careful Ways to Win with Options (benzinga.com)
A Detailed Options Trade for a Potential Apple Reversal (seekingalpha.com)

Options Trading Education

Succeeding in Options Trading

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Options Trading Leverage

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Buying Puts on the Financial Select Sector SPDR

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Trading Steel Options

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Trading Gold Options

Crisis Options Trading

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Good Times for Trading Options

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Options Trading CBOE

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Covered Options Trading

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Interest Rate Option Trading

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